Warning Signs of Low Quality Earnings

Summaries

Earnings Quality – conservatism of reporting earnings

1. Quality Earnings

2. Low Quality Earnings – following rules but misrepresent the economics of transactions

3. No Quality Earnings

Fraud Triangle:

Incentives/Pressures ó opportunities ó Attitudes/Rationalization

Warning Signs for low quality earnings:

1. Aggressive Revenue Recognition
2. Different growth rate of cash flow and earnings (cash flow/earning index should be stable and >1)
3. Abnormal sales growth/ margin – compared to industry and peers
4. Abnormal inventory growth compared to sales
5. Boosting income with nonoperating income and non-recurring gains (move income up the income statement)
6. Delay Expenses Recognition
7. Abnormal use of operating leases
8. High expenses classified as extraordinary/ nonrecurring (move expenses down the income statement)
9. LIFO liquidation (decrease of inventory in LIFO firms)
10. Extending the useful lives of long term assets
11. Year-end surprises
12. Aggressive pension assumptions
13. Equity method investments with little cash flow

Hedging:

1. Fair Value hedge – to hedge recognized asset/ reported in balance sheet/ G/L recognized in income statement
2. Cash flow hedge – to hedge anticipated cash flow/ G/L reported in balance sheet (equity, comprehensive income), then in income statement when occurs
3. Net investment hedge of foreign subsidiary – to hedge subsidiary’s earnings/ G/L recognized in balance sheet (equity, comprehensive income) with translation loss